Chapter 14: Lecture Notes Flashcards
What should be the basis for estimating all cash flows in capital budgeting?
All cash flows should be estimated on an after-tax basis because taxes can play an important role in any investment decision. The after-tax cost of capital is used to discount these cash flows, ensuring consistency.
What are marginal or incremental cash flows?
Marginal or incremental cash flows are the additional cash flows that result from capital budgeting decisions, including changes in existing flows from the firm’s decisions.
Example: If introducing a new product results in additional after-tax cash flows of $100,000 per year but causes a loss of $40,000 in after-tax cash flows from an existing product, the marginal cash flow is $60,000 per year.
Why should associated interest and dividend payments not be included in estimated project cash flows?
Associated interest and dividend payments should not be included because they are already accounted for in the discount rate, which captures all financing costs.
The weighted average cost of capital (WACC) is used for this purpose.
How should working capital adjustments be handled in cash flow estimates?
Cash flows should be adjusted to reflect any additional working capital requirements.
This includes the initial cash outlay and the terminal cash flow at the end of the project’s life.
For example, a project might require holding more inventory, tying up more funds.
What are sunk costs and how should they be treated in capital budgeting decisions?
Sunk costs are costs that have already been incurred, cannot be recovered, and should not influence current capital budgeting decisions.
They should be ignored in the analysis.
What are opportunity costs and how should they be factored into cash flow estimates?
Opportunity costs represent cash flows that must be forgone as the result of an investment decision.
Example: If a firm purchased land for $150,000 and can now sell it for $200,000, the $200,000 is the opportunity cost of using the land for a project and should be included in the cost.
How should inflation be treated in capital budgeting decisions?
Inflation must be treated consistently by comparing like with like:
Discount nominal cash flows with nominal discount rates
Discount real cash flows with real discount rates
What is the general formula for estimating Net Present Value (NPV)?
NPV = Σ [CFₜ / (1 + k)ⁿ] - CF₀
Where:
CFₜ = Cash flow in year t
k = Discount rate
CF₀ = Initial cash outlay
What is the initial after-tax cash flow (CF₀) in capital expenditure analysis?
The initial after-tax cash flow (CF₀) refers to the total cash outlay required to initiate an investment project.
This includes the initial capital cost, changes in net working capital (NWC), and associated opportunity costs.
How is the initial after-tax cash flow (CF₀) generally estimated?
CF₀ = C₀ + ΔNWC₀ + OC
Where:
C₀ = Initial capital cost of the asset
ΔNWC₀ = Change in net working capital requirements
OC = Opportunity costs associated with the project
What is the formula for estimating the annual operating cash flows using CCA tax savings?
CFₜ = CFBTₜ (1 - T) + CCAₜ (T)
Where:
CFBTₜ = Cash flow before taxes (incremental pre-tax operating income)
CCAₜ = CCA expense for year t
T = Firm’s marginal (effective) tax rate
What is the formula for estimating the Ending (Terminal) Cash Flow (ECFₙ) with tax implications?
ECFₙ (with tax implications) = SVₙ + ΔNWCₙ - 0.5 [(SVₙ - C₀) × T] - [(SVₙ - UCCₙ) × T]
Where:
SVₙ = Estimated salvage value in year n
ΔNWCₙ = Net working capital released at the end of the project
C₀ = Original capital cost of the asset
UCCₙ = Ending undepreciated capital cost balance
T = Firm’s effective tax rate
How do you calculate the present value (PV) of the CCA tax shield?
PV(CCA Tax Shield) = [(C₀)(d)(T) / (d + k)] × [ (1 + 0.5k) / (1 + k) ] - [(UCCₙ)(d)(T) / (d + k)] × [ (1 / (1 + k)ⁿ) ] - [(SVₙ - UCCₙ)(T) / (1 + k)ⁿ]
Where:
d = CCA rate
k = Discount rate
T = Effective tax rate
C₀ = Initial cost
UCCₙ = Ending UCC balance
SVₙ = Salvage value
What is the formula for calculating NPV using the valuation by components approach?
NPV = PV(Operating CFs) + PV(CCA Tax Shield) + PV(ECFₙ) - CF₀
Where:
PV(Operating CFs) = Present value of annual operating cash flows
PV(CCA Tax Shield) = Present value of the CCA tax shield
PV(ECFₙ) = Present value of the ending cash flow
CF₀ = Initial cash outlay
